Financing Through Musharaka:
Principles And Application

by Hussain G.
Rammal

Hussain
G. Rammal hussain.rammal@adelaide.edu.au
is Lecturer in International Management in the School of Commerce at The
University of Adelaide, 233 North Terrace, Adelaide, South Australia 5005,
Australia.

The purpose
of this article is to highlight the workings of Islamic finance in
general, and Musharaka as a financial instrument in particular.
Historically Musharaka was practiced by Arabs long before the
advent of Islam, and is therefore considered by many scholars to be
the most authentic form of Islamic contract. Musharaka is
based on the profit-and-loss sharing system where two or more
persons combine either their capital or labor together, and they
share in the profits and losses of their venture. While the demand for
Musharaka compared to other Islamic financial instruments is
relatively low, it is expected that in the future to defend the
system against criticism, more contracts will be established using
Musharaka as the financing option.

Introduction

Virtually unknown three decades ago, Islamic
financing is now practiced around the world. Since its official launch in the
1970’s, Islamic financial institutions have witnessed rapid international growth
in both Muslim and Non-Muslim countries (Dudley 2001).

Although the concept of Islamic finance has
existed for centuries, it only came into prominence during the last century (De
Jonge 1996, p.3). The first successful application of Islamic finance was
undertaken in 1963 by Egypt’s Mit Ghamr Savings Banks, which earned its income
from profit-sharing investments rather than from interest (Lewis & Algaoud 2001,
p.5). By the 1970’s, the push for Islamic finance had gained momentum. In 1973
the conference of foreign ministers of Muslim countries decided to establish the
Islamic Development Bank with the aim of fostering the economic development and
social progress of Muslim countries in accordance with the principles of
Shari’ah (Saeed 1996, p.13). This marked the first major step taken by
Muslim governments in promoting Islamic finance.

Shari’ah
law (Islamic law based on the teachings of the Koran) prohibits the followers of
Islam from conducting any business involving Riba (interest). This means
that Muslims cannot receive or pay interest, and they are, therefore, unable to
conduct business with conventional financial institutions (Jaffe 2002). The
creation of Islamic financial institutions came about as a method for servicing this niche
market.

In order to compete with
conventional modes of financing (interest-based financial instruments), Islamic
financial institutions developed products that would fulfill the Shari’ah
obligation and provide the same value as conventional bank products (Malaysian
Business 2001). The main Islamic financial products include profit-and-loss
sharing (Mudaraba and Musharaka), cost plus mark-up, and leasing.
The focus of this article is to analyze the profit-and-loss sharing instrument
of Musharaka and the way it is implemented. The article begins by
briefly describing the profit-and-loss sharing system, followed by a detailed
analysis of Musharaka. The article then looks at the application of
Musharaka as a home financing instrument, and concludes by analyzing the
current issues affecting Musharaka, and the criticism leveled against
it

Profit-And-Loss Sharing System

Although Islam excludes interest earnings from
financial activities, it does not necessarily mean that the financier cannot
earn a profit. In order to do so, the financier has to ensure that gains made on
the original amount are directly related to the risk undertaken on the
investment (Siddiqui 1987). If there is no risk involved, the gains made
represent interest rather than profit.

In order to understand how the Islamic system
differentiates between profit and interest, one has to look at the differences
in the economic ideology. In a capitalist system, capital and entrepreneurs are
treated as two separate factors of production. The return on capital is
interest, whereas the entrepreneur, who risks losing money, earns a profit.
While interest is a fixed return for providing capital, profit can only be
earned after distributing the fixed return to land, labor and capital (in the
form of rent, wage and interest). Thus, the capitalist system seems to favor
those who lend capital to entrepreneurs by providing them a secure return, entrepreneurs bear the
risks of incurring losses and still making interest payments on borrowed
capital.

In comparison, Islamic
economic system does not consider providers of capital and entrepreneurship as separate factors
of production. It believes that every person who contributes capital in the form
of money to a business venture assumes the risk of loss and therefore is
entitled to a proportional share in the actual profit (Siddiqui 1994, p.99). The
system is protective of the entrepreneur, who in a capitalist economy would have
to make fixed interest repayments even when the venture is losing money. (Usmani,
M.I. 2002, p.13). Capital has an intrinsic element of entrepreneurship, so far
as the risk of the business is concerned and, therefore, instead of a
fixed return as interest, it derives profit. The greater is the profit earned by
a business,
the higher the return on capital will be. With no fixed interest repayments, profit in an Islamic economic system would be higher than in the capitalist
economy. The system ensures that profits generated by commercial activities
in the society are distributed equally amongst those who have contributed
capital to the enterprise.

Another difference between
the two economic systems lies in the way money is used. In economic terms money
has no intrinsic value; it is only a medium of exchange, therefore, earning
interest on a medium of exchange without bearing any risks does not sit well in
the Islamic system (Rahman 1994, p.14). Islamic financing is, therefore, an
asset-backed financing. When a financier contributes money on the basis of the
profit-and-loss sharing instruments, it is bound to be converted into assets
having intrinsic value (Usmani, M.T. 1998, p.19).

The profit-and-loss sharing system has its
roots in the ancient form of financing practiced by Arabs since long before the
advent of Islam. After the introduction of Islam, this system was permitted to
continue and was legitimatized as a finance instrument. For this historical
reason, scholars consider profit-and-loss sharing financial instruments to be
the most authentic and most promising form of Islamic contracts (Ariff, 1982).
Mudaraba (finance trusteeship) and Musharaka (equity partnership)are two such financial instruments based on the profit-and-loss sharing
system, where instead of lending money to an entrepreneur at a fixed rate of
return, the financier shares in the venture’s profits and losses (The Economist
2001).

Musharaka

The literal meaning of the word Musharaka
is sharing. Under Islamic law, Musharaka refers to a joint partnership
where two or more persons combine either their capital or labor, forming a business in which all partners share the profit according
to a specific ratio, while the loss is shared according to the ratio of the
contribution (Usmani, M.I. 2002, p.87). It is based on a mutual contract, and,
therefore, it needs to have the following features to enable it to be valid:

Parties should
be capable of entering into a contract (that is, they should be of legal
age).

The contract
must take place with the free consent of the parties (without any duress).

In Musharaka,
every partner has a right to take part in the management, and to work for it (Gafoor
1996). However, the partners may agree upon a condition where the management is
carried out by one of them, and no other partner works for the Musharaka.
In such a case the "sleeping" (silent) partner shall be entitled to the profit only to the
extent of his investment, and the ratio of profit allocated to him should not
exceed the relative size of his investment in the business.

However, if all the partners agree to work for
the joint venture, each one of them shall be treated as the agent of the other
in all matters of business, and work done by any of them in the normal course of
business shall be deemed as being authorized by all partners (Usmani, M.I. 2002,
p.92).

Musharaka
can take the form of an unlimited, unrestricted, and equal partnership in which
the partners enjoy complete equality in the areas of capital, management, and
right of disposition. Each partner is both the agent and guarantor of the other.
Another more limited investment partnership is also available. This type of
partnership occurs when two or more parties contribute to a capital fund, either
with money, contributions in kind, or labor. Each partner is only the agent and
not the guarantor of his partner. For both forms, the partners share profits in
an agreed upon manner and bear losses in proportion to the size of their capital contributions
(Lewis & Algaoud 2001, p. 43).

‘Interest’ predetermines a fixed rate of return
on a loan advanced by the financier irrespective of the profit earned or loss
suffered by the debtor, while Musharaka does not envisage a fixed rate of
return. Rather, the return in Musharaka is based on the actual profit
earned by the joint venture. The presence of risk in Musharaka makes it
acceptable as an Islamic financing instrument. The financier in an
interest-bearing loan cannot suffer loss, while the financier in Musharaka
can suffer loss if the joint venture fails to produce fruits (Usmani, M.T.
1998, p.27).

Musharaka In Home Financing

When used in home financing, Musharaka
is applied as a diminishing partnership. In home financing, the customer forms a
partnership with the financial institution for the purchase of a property (Saeed
2001). The financial institution rents out their part of the property to the
client and receives compensation in the form of rent, which is based on a
mutually agreed fair market value. Any amount paid above the rental value
increases the share of the customer in the property and reduces the share of the
financial institution.

The application of diminishing Musharaka
in home financing can be illustrated with the help of the following example,
which the LaRiba bank in the U.S. follows:

Let us assume that a potential buyer is
interested in purchasing a home worth $150,000. The buyer approaches an Islamic
financial institution for the purchase of the property and puts 20 per cent of
the price ($30,000) as down payment (the down payment required differs between
financial institutions. In some cases it is as low as 5 percent ). The
financial institution pays for the other 80 per cent of the price ($120,000).
This agreement results in 20 per cent of the home ownership belonging to the
client and the remaining 80 percent to the financial institution.

The next step for both parties would be to
determine the fair rental value for the property. One way to determine the
rental value is for both the client and financial institution to survey the
market to obtain estimates for similar properties in the same neighborhood and
negotiate an agreement. This fair rental value will remain constant over the
life of the agreement. For this example, we will assume $1,000 per month as the
rental value.

A rental value of $1,000 means that the client
will pay $800 as rent for the 80 per cent share the financial institution holds.
The two parties then agree on the period of financing. In this example we will
assume that the financing period is 15 years (180 months). Based on the rental
value and the financing period, the financial institution then determines the
fixed monthly payments the client would have to make to own the house.

Table 1

Example of payment
schedule for a home-loan under Musharaka.

Month

Rent
$

Extra Payment $

Total Fixed Payments $

Bank's Ownership $

Opening

120,000

1

800

347

1147

119,653

2

798

349

1147

119,304

…

……

…..

…..

……

176

37

1110

1147

4,439

177

30

1117

1147

3,322

178

22

1125

1147

2,197

179

15

1132

1147

1,065

180

7

1065

1072

0

In this example the
client starts by paying $1147, which includes the required 80% of the $1,000,
and extra payment of $347. By doing so the client reduces the share of the
financial institution by $347, and increases their own share by the same amount.
The next month’s rental payment of the client would be reduced to $798, and
again the payment made above the rent amount will result in an increase in the
client’s ownership of the property. This continues on till the client buys back
all the shares of the home that the financial institution holds at the end of
the agreed financing period.

This example does not take into account fees
and charges that the financial institution may charge such as insurance and
taxes.

In the event of non-payment of rent from the
client, the financial institution has to take into consideration the reason for
the non-payment. If the client has a valid excuse for non-payment, the financial
institution has to show leniency so that the client does not feel over-burdened,
and the client should give more time to make the payment. In theory, if the
financial institution charges any extra amount as compensation for the late
payment, the amount would be considered as interest and therefore is not
permitted in Islam. If there is no genuine reason for the late payment, the
financial institution can ask the client to make a payment to a charity as
penalty (Usmani, M.T. 1998, p.172). This prohibition of charging late fees makes
it even more important for Islamic financial institutions to carefully evaluate
each application before entering into an agreement.

Criticism Of Musharaka

Musharaka
is sometimes criticized as being an old instrument that cannot be applied in the
modern world. However, this criticism is unjustified. Islam has not prescribed a
specific form or procedure for Musharaka. Rather it has set some broad
principles which can accommodate numerous forms and procedures (Usmani, M.T.
1998, p.29). A new form or procedure in Musharaka that would make it
suitable for modern financial needs cannot be rejected merely because it has no
precedent in the past. In fact, every new form can be acceptable as long as it
conforms to the principles laid down by Shari’ah. Therefore, it is not
necessary that Musharaka be implemented only in its traditional form
(Usmani, M.T. 1998, p.30).

Another criticism
leveled against Musharaka is based upon the issue of profits being
guaranteed by some financial institutions. Even though Musharaka is
considered to be the most authentic form of Islamic financing, the risk
associated with sharing losses means that it is not as popular as the other
modes. To make the product more appealing to the customer, some financial
institutions have started guaranteeing profits in Musharaka. By doing so,
these institutions are contravening the basic law of Islamic finance that requires
linking rewards to risks (Warde 2000, p.5). If profits are guaranteed, the risk
factor is eliminated, making the profit resemble interest. Although these
actions may help Islamic banks grow in the short-run, the long-term costs (harm
to reputation and authenticity) will outweigh the benefits. Such moves also
provide ammunition to the critics of the system, who are already questioning
whether the system is nothing more than an interest-based system operating under
the guise of profit (The Economist 1994).

Conclusion

Although not as popular
as other Islamic financial instruments, Musharaka is still considered to
be one of the most authentic forms of Shari’ah approved financing.
Recognising the problem that some financing instruments used by Islamic
financial institution closely resemble interest-bearing instruments, Muslim
scholars have voiced their opinion that more profit-and-loss sharing instruments
should be developed and used. In recent times there have also been calls for
Muslim countries to follow the lead of Iran and Pakistan, where their governments
have enforced the Islamic financial system as the only available finance option.
The push for such actions to be taken means that Musharaka’s use as an
Islamic financial instrument will continue to rise in the future. Also, by
relying on Musharaka for financing projects, Islamic financial
institutions can erode any fears that Islamic financial institutions are
essentially providing interest-bearing products under the guise of profit and
mark-up has hurt their reputation. This is important for the survival and future
growth of Islamic finance.